Statements in Financial Analysis

Transcription

1 Intro to Finance Introduction to Finance by George W. Blazenko All Rights Reserved 2008, 2014 Chapter 2 Financial Statements in Financial Analysis There's no business like show business, but there are several businesses like accounting. David Letterman The average parent may, for example, plant an artist or fertilize a ballet dancer and end up with a certified public accountant. Ellen Goodman (b. 1941), U.S. journalist. Goodman s Victory Garden, Close to Home, Simon & Schuster (1979). 1

2 Financial Statements in Financial Analysis Chapter Two Contents (2.1) Introduction... 3 (2.2) Recognize the Limitations of Financial Ratios A SPREADSHEET TEMPLATE FOR FINANCIAL RATIOS 8 (2.3) The Income Statement EBITDA MARGIN DEPRECIATION NET INCOME 13 (2.4) The Accounting Balance Sheet ASSETS 15 (2.5) Invested Capital THE FINANCIAL DEFINITION OF INVESTED CAPITAL THE OPERATING DEFINITION OF INVESTED CAPITAL 18 (2.6) Business Returns THE RATE OF RETURN ON INVESTED CAPITAL (ROIC) THE RATE OF RETURN ON EQUITY (ROE) THE RELATION BETWEEN ROIC AND ROE WHY ARE ROIC AND ROE BOTH IRRS? 28 (2.7) Free Cash Flow THE OPERATING DEFINITION OF FREE CASH FLOW THE FINANCIAL DEFINITION OF FREE CASH FLOW AFTER TAX DISTRIBUTIONS TO CREDITORS NET DISTRIBUTIONS TO SHAREHOLDERS 35 (2.8) Additional Invested Capital Ratios DEBT TO INVESTED CAPITAL TRADE CAPITAL TO INVESTED CAPITAL EBITDA MARGIN AND INVESTED CAPITAL TURNOVER 39 (2.9) Net Working Capital and Liquidity (2.10) Efficiency of Trade Capital Utilization TURNOVER RATIOS THE CASH CONVERSION CYCLE 44 (2.11) Summary (2.12) Suggested Readings (2.13) Appendix: Industry Ratios DEFINITIONS 48 (2.14) Problems (2.15) Chapter Index

3 Intro to Finance (2.1) Introduction Title Page Financial accounting is the process of producing and disseminating information about the economic activities of a firm. Accountants prepare annual and quarterly reports, and more specifically, financial statements, to transmit this information to interested readers. Many groups require information from financial statements, including shareholders, creditors, employees, suppliers, government, and social interest groups. Financial statements are general summaries of economic activity because user groups have diverse interests. Perhaps because of this diversity, accountants take pains to ensure accuracy of the information presented in financial statements but they provide no guidance on their use. One goal of this book is to explain how investors use financial statement information to analyze business and financial investments. For at least two reasons, communication is weaker between professional accountants and users of financial statements than between other professionals and their clients. First, accounting principles and the pronouncements of regulatory agencies tightly constrain the content and format of statements issued for corporations and especially for publicly traded firms. Second, not only do users of financial statements have little opportunity to make direct requests of accountants for individual treatment, but also the users of financial statements must share one set of statements, in spite of diverse interests. Since the relation is weak between users of financial statement and producers of financial statement, a second goal of this book is to provide a framework for those who prepare financial statement to assess the informational requirements of investors. In this chapter, we integrate ratio calculations into financial analysis, which we know from Chapter 1 answers the question is this good investment? The perspective that we develop in this chapter has its origins in the investment industry. We emphasize the perspective of financial analysts, who use financial ratios to make investment decisions. 3

4 Financial Statements in Financial Analysis (2.2) Recognize the Limitations of Financial Ratios Title Page You should be aware of several limitations of financial ratios in financial analysis (the four questions for any investment from chapter one). First, there is no objective standard for most ratios. What constitutes a high or a low value for a ratio is often a question of business judgment rather than business theory. Financial ratios measure business performance, efficiency, and risk. If used carefully, ratios can be valuable as a tool to assess the financial health of a firm. For most ratios, however, it is difficult to determine whether the value of a ratio for a firm is good or bad, high or low. The reason for this uncertainty is that the theory of business is not yet sufficiently strong to offer absolute standards for most ratios. Until we have a more complete theoretic picture, we must resort to using relative rather than absolute comparisons. Relative comparisons include trend analysis and industry average comparisons of ratios. In trend analysis a financial analyst determines whether a ratio is improving or deteriorating. In an industry average comparison, an analyst determines whether a ratio is better or worse than the industry. Neither benchmark answers the question whether the ratio is good or bad. There is one exception to the general rule that the theory of business is not sufficiently strong to give us absolute benchmarks. The exception is the theory of finance. In finance we can benchmark returns against an opportunity cost rate of return from financial markets, which is a number. How to calculate financial market opportunity costs is a major objective of this textbook and all of financial study. With an opportunity cost rate of return from financial markets, we can answer the question whether business returns are good or bad. 4

5 Intro to Finance An example of an absolute standard for a return is our first numerical example in this book from Chapter 1. A firm invests $300,000 today to generate (forecast) $400,000 in one year. We determined in Chapter 1 that the return on this business investment, calculated as the IRR, is 33.3%. We said (without giving the details) that the opportunity cost rate of return from financial markets is 7%. This number, 7%, is an absolute standard with which to benchmark the 33.3% business return. Because the 33.3% is greater than the 7% we said that this was a good investment. The theory of finance is sufficiently strong to give us an absolute standard for returns. Any return, like, for example, the rate of return on invested capital (ROIC) or the rate of return on equity (ROE), that we calculate in this chapter can be benchmarked against financial market opportunity costs. We reserve that benchmarking for later in this textbook after we have learnt more about financial markets and how these markets determine opportunity cost rates of return. It makes little sense to benchmark a firm s ROIC or ROE against industry averages or past values of these return ratios. These are relative benchmarks when a much better absolute benchmark is available. The financial opportunities available to shareholders and other financial asset-holders are much broader than the particular firm under investigation or even its industry. Investors can invest in the financial assets of any public company around the world. To recognize this broad perspective for opportunity costs of investors we must benchmark returns against financial market returns of about the same risk. Second, differences between firms' accounting methods limit the comparability of many ratios. Therefore, where there is a choice as to measure, seek to use ratios that are unaffected by arbitrary choices of accounting treatment. Third, some ratios that share the same name are calculated in different ways. Different accounts can be included or excluded; and broader or narrower interpretations might be employed for different classes of financial assets. Because theory in this area is not yet strong enough to tell us exactly what or how to measure, then naturally, different analysts employ different measures, and in different ways. The set of ratios described in this chapter, which is essentially the same as the ratios in The Canadian Securities Course text, is well suited to financial analysis. 5

6 Financial Statements in Financial Analysis An industry average might not be an appropriate objective for your firm. If a whole industry is inefficient, it makes little sense to applaud a move towards the industry average. On the other hand, a firm that is better than the industry in any one dimension is not necessarily in peak financial health. Industry averages conceal significant variation, which typically exists for any ratio across firms in the industry. One interpretation of this variation is that, even for firms in the same industry, there is not necessarily a best value for a particular ratio. There may, in fact, be different paths to robust financial condition. Industry comparison is a narrow perspective on corporate benchmarking. Remember that the objective of a firm is to maximize shareholder wealth. While you, as an employee of your firm, may be particularly interested in how the firm performs relative to your competitors, shareholders have a broader perspective. Shareholders are restricted neither to investing in any one firm, nor to any one industry. Each firm must compete globally for the financial resources of dispassionate investors who choose to invest wherever they like, in many different firms and in many different industries. If an industry performs poorly relative to other industries, each firm in the industry suffers the financial consequences just as surely as if a firm performs poorly relative to industry competitors. If your objective is to maximize shareholder wealth, then you must maintain a broader perspective on performance than the perspective allowed by a simple industry comparison of ratios. Fourth, another shortcoming of traditional financial statement analysis is that financial statements are used as the exclusive source of information. Even though financial statements provide an analyst with firm-specific information, the theory of business organizations is not yet sufficiently strong to provide an analytically determined absolute standard against which this information can be compared. Therefore, ratios are compared with prior time-periods or against industry standards to assess performance. We can build a consistent conceptual framework from recent advances in economic and financial theory. In this book, we use discounted cash flow analysis as a theory of value and we use financial statements and financial market data as inputs. The broad outline goes like this. Estimate prospective rates of return that a firm can earn for its suppliers of capital. Compare prospective returns to objective measures of corporate 6

7 Intro to Finance performance, like the average return on financial assets of equivalent risk. We need firm-specific information to estimate prospective returns. We also need financial market data to access investor benchmark opportunity costs. Firm-specific information from financial statements and financial market information are combined by employing the techniques of discounted cash flow analysis to establish intrinsic values for firms' real assets and financial assets. Armed with intrinsic-value estimates, we can make informed investment decisions. In our numerical example from Chapter 1, we might use financial statement data to help us predict that the rate of return on business investment is 33%. On the other hand, we investigate financial markets to determine that the opportunity cost of this real asset investment is a 7% rate of return. Both components of this analysis are crucial to making an informed business decision. So, financial statements and ratios calculated from these financial statements are at best one ½ of a complete financial analysis. The other half of our financial analysis is the determination of the 7% opportunity cost rate of return from financial markets. Without this benchmark, we cannot answer the fourth question of financial analysis is this a good investment? Fifth, a final limitation of using financial statements in our financial analysis is that financial statements are historical but our theory of value, NPV, has a future (forward) orientation. We know from Chapter 1 that we determine whether an investment is good based on whether NPV is positive or not. The cash flows that we discount in NPV are predicted future cash flows (without giving the details). On the other hand, financial accounts recognize only transactions that have taken place in the past. Nonetheless, the past does bear some resemblance to the future. So, we can use the financial statements of firms to help us predict future cash flows. In particular, corporate returns from financial statements, like the rate of return on invested capital or the rate of return on equity (that we calculate in this chapter), have a persistence property that makes them invaluable for forecasting future corporate results. The persistence property is that if the rate of return on invested capital was high last year, it will tend to be high this year. Recognize, however, that not all returns have this persistence property. For example, because of the special features of financial markets returns (they are determined from financial asset prices that depend upon investors expectations of the future), these returns do not generally have the persistence property. Or, possibly better said, returns in financial markets do not have the persistence 7

8 Financial Statements in Financial Analysis property nearly to the same extent as do corporate returns (like, for example, the rate of return on invested capital). If the rate of return on a publicly traded company last year was high, then, this observation tells you little about its expected rate of return for the upcoming year. Benchmarking is an especially valuable use of ratios. Suppose for example, that we forecast operating results predicted for a new business venture. If our forecast financial statements produce financial ratios that are far from the industry average or far from the firm s historic experience, then we have grounds to reconsider the assumptions of our planning exercise. In this way, ratio analysis imposes discipline on assumptions we use in financial planning. We use ratio analysis again when we discuss financial planning and capital budgeting in later chapters A Spreadsheet Template for Financial Ratios Title Page The worksheet embedded below calculates all ratios we discuss in this chapter for Canadian Pacifica Railway (CPR). CPR provides rail and freight transport services over a 14,400-mile rail network serving major Canadian business centers from Montreal to Vancouver and in the US Midwest and Northeast. CPR is a public company with common shares traded on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). Canadian Pacific Railway The CPR workbook above serves also as a template for ratio analysis of other firms. Required inputs are the income statement and the balance sheet. The spreadsheet then automatically calculates each of performance measures we develop in this chapter. We retrieve CPR data from a database called COMPUSTAT which is a product of Standard and Poor s Corporation. This database provides mostly financial statement information on over 10,000 publicly traded North American firms. The graphical user interface is called Research Insight. 1 Research Insight has many predefined reports. Two of these reports are an income 1 Research Insight is available for BUS312 students at the Beedie School of Business, Simon Fraser University, in the Beedie Computer Lab in Room

9 Intro to Finance statement and a balance sheet over the last five fiscal years. We use these two reports to calculate ratios for CPR in the above EXCEL workbook. In producing these two reports, Research Insight adjusts the financial statements to standardize accounting conventions and uses common line items for both the income statement and balance sheet for all companies, which enhances ratio comparability across companies. The following section begins our discussion of financial ratios and financial analysis by describing the two principal financial statements: the income statement and the balance sheet. (2.2) The Income Statement Title Page Within the confines of generally accepted accounting principles and other accounting conventions, the income statement measures the increment to shareholders' wealth over a specific period of time generally a quarter or a year. The shareholder orientation of this statement makes it of central importance to existing and potential shareholders. Income statements appear in a variety of forms but all satisfy the fundamental relationship: Net Income = Revenues Expenses. Revenue is a measure of the benefit of sales events in a period: price times the number of units sold summed over the different products and services sold by the firm. In the 2013 income statement for CPR below we see that Sales for 2013 are $5,765,723 (numbers are in thousands). A common decomposition of financial statement expenses is Costs of Sales (also referred to as costs of goods sold), Selling, General and Administrative Expenses, Depreciation, and Interest. Costs of Sales measures expenses associated with production: materials and supplies, direct labor costs, freight-in, heat, light, power, insurance and safety, maintenance and repairs, salaries, and warehouse costs. Selling, General and Administrative Expenses include all commercial expenses of operation not directly related to production but incurred in the course of business activity: sales commissions, advertising expense, marketing expense, freight-out, pension, retirement, profit sharing, provision for bonus and stock options, and other employee benefits. Occasionally, depreciation is included in general and administrative expenses. 9

10 Financial Statements in Financial Analysis Exhibit 2.1: Income Statement Canadian Pacific Railway PERIOD ENDING 31-Dec Dec Dec Dec-10 Total Revenue 5,765,723 5,719,020 5,084,000 5,013,000 Cost of Revenue 2,100,592 2,325,166 2,253,000 1,957,000 Gross Profit 3,665,131 3,393,854 2,831,000 3,056,000 Operating Expenses Research Development Depreciation 531, , , ,000 Selling General and Administrative 1,400,395 1,550,111 1,400,000 1,440,000 Non Recurring Others Total Operating Expenses 1,931,560 2,091,384 1,881,000 1,932,000 Operating Income or Loss 1,733,571 1,302, ,000 1,124,000 Total Other Income/Expenses Net -397, ,548-1,800 12,000 Earnings Before Interest And Taxes 1,335, , ,200 1,136,000 Interest Expense 278, , , ,000 Income Before Tax 1,057, , , ,000 Income Tax Expense 235, , , ,000 Minority Interest Net Income From Continuing Ops 822, , , ,000 Non-recurring Events Discontinued Operations Extraordinary Items Effect Of Accounting Changes Other Items Net Income 822, , , ,000 Preferred Stock And Other Adjustments Net Income Applicable To Common Shares 822, , , ,000 effective tax rate Cash Dividends (Total) 229, , , ,343 Sales less Costs of Sales equals Gross Income or Gross Profit From Operations. Gross profit is a measure of the profitability of a firm's production. The term operations is typically used in connection with a firm's fundamental business activity (before distributions are made to suppliers of capital like dividends and interest). This separation of operations from financing activity is of critical importance if one is to disentangle shareholders' benefits from a firm's business activity and shareholders' benefits from financing activities. 10

11 Intro to Finance Because gross profit is measured in dollars, inter-firm comparison of gross profit is meaningless until we consider the size of each firm. Financial analysts facilitate inter-firm comparison by calculating gross profit margin: gross profit divided by sales. Because gross profit margin is a percentage, it is comparable across firms. However, because financial accountants have discretion in the classification of expenses as cost of goods sold or general and administrative, the comparability of this ratio across firms is limited. For CPR, 2013 gross profit is $5,765,723-$2,100,592 = $3,665,131 and gross profit margin is 63.6% EBITDA Margin Title Page Gross profit less selling, general, and administrative expenses (before depreciation and amortization) equals earnings before interest, tax, depreciation and amortization which is often abbreviated as EBITDA 2. EBITDA measures profitability of a firm's operations, net of both production and commercial expenses. Financial analysts calculate net operating margin (which is also referred to as the EBITDA margin) as EBITDA divided by sales. EBITDA Margin EBITDA Sales In 2013, CPR EBITDA margin was $2,264,736/$5,765,723 = 39.3% The EBITDA margin is designed for comparability across firms because taxes, interest expense, depreciation and amortization are excluded. These four income statement line items are influenced by the idiosyncratic characteristics of individual firms. For example, tax expense varies with firm size, and with the existence of prior year losses that offset current-year taxable income. Interest expense depends on the amount of debt used by a firm, which is more or less discretionary. Accountants choose depreciation schedules and this choice need not be the same even for firms in the same industry. For these reasons, any financial ratio that depends on tax expense, depreciation, or interest has limited comparability across firms. 2 EBITDA is also typically calculated before the line items other income and extraordinary income (or loss). Each of these amounts is either non-recurring or outside the firm s normal business practice. Therefore, EBITDA as described in the text above is sometimes referred to as EBITDA from core operations. For simplicity, unless otherwise stated in this book, when we use the term EBITDA we really mean EBITDA from core operations. 11

12 Financial Statements in Financial Analysis The EBITDA margin is a measure of operating efficiency. It measures the fraction of $1 of sales, which goes to the bottom line after production and commercial expenses (that is, to EBITDA). In later chapters, we will see that the EBITDA margin is also a measure of operating risk. In the appendix to this chapter, the EBITDA margin is sorted and presented for 302 different industry averages. The median value for the EBITDA margin for firms in the North American economy is approximately 10.5%. This value is useful for benchmarking North American firms with respect to operating efficiency and operating risk. What question of financial analysis are we investigating with the EBITDA margin? The answer is the EBITDA margin is a component of return. It is not a return itself. However, when multiplied by another ratio that we will calculate shortly, you get a business return and returns are, of course, very important in financial analysis Depreciation Title Page Economic depreciation is the reduced ability of an asset (generally a real asset) to generate future cash flows. Because the value of an asset depends upon the future cash flow that it produces, economic depreciation decreases the value of assets. An obvious factor in economic depreciation is asset usage. Assets used more intensely deteriorate more quickly, and therefore, economic depreciation should depend on the level of use. Nonetheless, the objectivity principle of financial accounting requires that financial statements be prepared from readily verifiable data. Therefore, accountants estimate economic depreciation according to predefined schedules that are invariant to asset use. For example, the most commonly used depreciation schedule is straight-line depreciation. Yearly depreciation equals the cost of the asset, less estimated salvage value, divided by estimated years of useful life. Shareholders bear the burden of economic asset depreciation and net income recognizes economic depreciation but only with a crude approximation. This approximation is the depreciation line item that is seen on the income statement as an expense. Note well, however, that the deduction for depreciation is non-cash expense. Firms do not actual pay, in the sense of a cash outflow, for depreciation. They do, however, benefit from the tax-deduction for 12

13 Intro to Finance depreciation allowed by the government for the purpose of income taxation. A tax- deduction is an expense for tax purposes that decreases taxable-income and, thus, decreases the tax-bill of a corporation Net Income Title Page Net operating profit less interest, taxes, depreciation and amortization equals net income (often referred to as earnings). Net income divided by sales is net profit margin. Within the confines of generally accepted accounting principles (GAAP), net profit margin is the increase in shareholders' wealth for every dollar increase in sales, or equivalently, the net benefit of sales activity to shareholders. For this reason, net profit margin is also referred to as return on sales. Interest is subtracted in the calculation of net profit margin, and therefore, this interpretation is conditional on the current financial structure of the firm (i.e., the firm's use of debt financing). Net profit margin is a commonly calculated financial ratio but because it incorporates interest, taxes, depreciation and amortization, its usefulness for inter-firm comparison is limited. For inter-firm comparison, the EBITDA margin is a more reliable measure of operating efficiency. (2.3) The Accounting Balance Sheet Title Page The purpose of the accounting balance sheet is to summarize resources of the firm available for conducting business operations (assets) and claims against these assets (liabilities and shareholders equity). The accounting balance sheet describes transaction amounts rather than values. On the other hand, it is the purpose of financial analysis to estimate investment values. Exhibit 2-2 illustrates fiscal year-end balance sheets for 2004 to 2013 for CPR. 13

14 Financial Statements in Financial Analysis Exhibit 2.2: Balance Sheet CPR PERIOD ENDING 31-Dec Dec Dec Dec-10 Assets Current Assets Cash And Cash Equivalents 833, ,404 46, ,000 Short Term Investments Net Receivables 545, , , ,000 Inventory 155, , , ,000 Other Current Assets 373, ,324 51,000 48,000 Total Current Assets 1,907,493 1,334, ,000 1,211,000 Long Term Investments 112,814 83, , ,000 Property Plant and Equipment (net of accumulated Depreciation) 12,528,909 13,067,885 12,523,000 12,074,000 Goodwill Intangible Assets 152, , , ,000 Accumulated Amortization Other Assets 1,336, , , ,000 Deferred Long Term Asset Charges Total Assets 16,038,357 14,789,114 13,857,000 13,763,000 Liabilities Current Liabilities Accounts Payable 1,117,796 1,190,960 1,113,000 1,014,000 Short ST Debt/Current Long Term Debt 177,682 54,228 76, ,000 Other Current Liabilities Total Current Liabilities 1,295,478 1,245,188 1,189,000 1,298,000 Long Term Debt 4,406,318 4,655,553 4,611,000 4,059,000 Other Liabilities 935,414 1,679,052 1,705,000 1,594,000 Deferred Long Term Liability Charges 2,729,153 2,090,823 1,786,000 1,957,000 Minority Interest Negative Goodwill Total Liabilities 9,366,363 9,670,616 9,291,000 8,908,000 Stockholders' Equity Misc Stocks Options Warrants Redeemable Preferred Stock Preferred Stock Share Capital 2,137,821 2,177,145 1,821,000 1,825,000 Retained Earnings 4,534,173 2,941,353 2,744,000 3,030,000 Treasury Stock Capital Surplus Other Stockholder Equity Total Stockholder Equity 6,671,994 5,118,498 4,565,000 4,855,000 Liabilities + Equity $16,038,357 $14,789,114 $13,856,000 $13,763,000 14

15 Intro to Finance Assets Title Page Assets are commonly categorized as current assets and non-current assets. Current assets are those assets which are expected to be transformed (in the normal course of business activity) into cash in the relatively near term (i.e., within a fiscal year). The most commonly described current assets on the balance sheet are Cash and Marketable Securities, Accounts Receivable, and Inventories. Marketable securities are financial assets of other corporations or governments held as short-term investments. Because marketable securities are extremely liquid, they are considered cash equivalents. Accounts receivable are amounts due from customers less an estimate of amounts unlikely to be paid (doubtful accounts). Inventories include both finished product inventories and raw materials inventories. Inventory is recorded at cost of purchase or production. When finished goods are sold, the periodic cost of goods sold is incremented and inventory on the balance sheet is decremented (recall the accounting matching principle). The balance sheet figure for inventories depends upon whether inventory is decremented by the cost of units first placed in inventory (first in first out inventory accounting FIFO) or by the cost of units last placed in inventory (last in first out inventory LIFO). Non-current assets are held by corporations to support production and commercial operations over a relatively longer horizon than a fiscal year. The most common category of non-current assets described on an accounting balance sheet is Property, Plant and Equipment (often labeled fixed assets). These fixed assets are recorded at original cost less accumulated depreciation. The financial side of the balance sheet liabilities and shareholders' equity describes cumulative (over time) sources of funds used to finance the firm s assets. Liabilities are commonly segregated into current liabilities and non-current, or long-term, liabilities. Current liabilities are expected to be paid within a fiscal year. 15

16 Financial Statements in Financial Analysis Current liabilities are commonly composed of short-term debt, accounts payable, income taxes payable, salaries and wages payable, and the current portion of long-term debt. Short-term debt is formal borrowing by the firm from either commercial banks or by selling short-term debt securities. The market that trades short-term debt securities is called the money market. The term money is used because securities that trade in this market have many characteristics of money. In particular, such debt instruments mature in less than one year and carry minimal risk of default. Accounts payable are amounts owing suppliers. Wages and salaries payable are amounts owing employees. These amounts are contained within the line item Accrued Expenses. The current portion of long-term debt or equivalently Long Term Debt Due in One Year is the amount of principal on long-term debt that the firm expects to repay over the course of the upcoming fiscal year. CPR primary sources of long term financing are long term debt and common equity. At the end of 2013 CPR long term debt was $4,406,318. Since long term debt due in one year is the amount of principal on long term debt scheduled to be repaid over the course of the upcoming year, long term debt on the balance sheet is the amount of principal on long term debt scheduled to be repaid after one year from today. CPR has two common equity accounts: Share Capital and Retained Earnings. Share capital is the expenditure by original founding shareholders plus the sale of new shares to new shareholders less the repurchase of shares by CPR. Retained earnings is the accumulation of net income over the years less cash dividends. (2.4) Invested Capital Title Page Returns are critically important in financial analysis. We are working toward calculating the equivalent of the 33.3% business return we calculated in Chapter 1 as an IRR but for real rather than stylized companies. If a firm invests $300,000 to generate $400,000 in one year, the business return is 33.3% per annum. In real world financial analysis, if we want a good measure of return, we need a good measure of expenditure, which is the equivalent of the $300,000 in the above example. Expenditure is one of the fundamental questions of financial analysis that we 16

17 Intro to Finance identified in Chapter 1. Financial statements and a balance sheet in particular are not designed to answer this expenditure question. So, in this section, we rearrange a balance sheet to calculate expenditure with Invested Capital. We can measure Invested Capital from the corporate perspective (business investment) or from the financial asset-holder perspective (shareholders and creditors are the primary financial investors in any corporation). So, there are two calculations for invested capital: the financial calculation and the operating calculation. We begin with the financial calculation because Invested Capital originates in the investment industry The Financial Definition of Invested Capital Title Page The total of all funds that have been invested by financial asset-holders in a firm is referred to as invested capital. The term invested is used because these funds are associated with identifiable financial assets sold by the firm. Invested capital is a measure of expenditure by financial asset-holders rather than a measure of the value of these financial assets. All accounts on the financial side of the balance sheet that are associated with financial investing are included in the calculation of invested capital. Invested capital is a commonly used measure in the investment industry because it provides a good organizing framework for analysis. It helps to separate the two sides of the coin which is the corporation, the operating side and the financial side. The below table gives one definition of Invested Capital in common use by investors applied to CPR for You will see shortly why we use 2012 rather than This table tells us that at the end of 2012, the financial asset-holders of CPR (creditors and common shareholders) have invested over 13.5 billion dollars into the financial assets of CPR. Note carefully, however, that this is an expenditure calculation. The value of CPR financial assets may have increased or decreased since their original investment of financial asset-holders. Invested Capital is an expenditure calculation and not a value calculation. 17

18 Financial Statements in Financial Analysis Exhibit 2.3: Financial Definition of Invested Capital: CPR 2012 ST Debt plus Current Portion of LT Debt LT Debt and other LT Liabilities Deferred Taxes Preferred Shares Share Capital Retained Earnings Other Financial Assets $54,228 4,655,553+1,679,052+2,090,823=$8,479, $2,177,145 $2,941,353 0 Invested Capital in the Financial Calculation $13,598,154 If we define debt as short-term debt plus long-term debt plus other long-term liabilities, then debt for CPR for year-end 2012 is $54,228 + $8,479,656 = $8,479,656. If we define Equity (that is, book equity) as the sum of Share Capital and Retained Earnings, then Equity at yearend 2012 for CPR is $2,177,145 + $2,941,353 = $5,118,154. You should locate both these numbers in the Invested Capital Balance Sheet in exhibit 2-4 below, which summaries our investigation of expenditure for this company The Operating Definition of Invested Capital Title Page If invested capital in the financial calculation measures the amount that financial asset-holders have invested in the financial assets of a firm, then the other side of the coin (the corporation) measures business investment by the corporation for the benefit of all financial asset-holders (generally creditors and common shareholders). This is the operating definition of invested capital. Firms make two general types of business investments. First, firms invest in what might be termed their trading function. Firms make trades associated with the two components of the income statement, revenues and expenses. Sales represent trades that firms make with their customers. Expenses represent trades that the firm makes with their suppliers, employees, landlords, and the government. Firms must make an investment into short-term assets in order to support this trading function. For example, accounts receivable are held to support credit sales. Inventories are held to ensure that sales can take place when requested by customers. Some of 18

19 Intro to Finance these short-term investments can be financed with deferred payments associated with trades that the firm makes with product and service suppliers. These deferred payments are measured on the accounting balance sheet as, for example, accounts payable, wages payable, and income taxes payable. Income taxes payable can be thought of as a deferred payment for the infrastructure services provided by the government. The net amount which firms must hold to support the trading function associated with their operations is referred to as trade capital. Trade capital equals current assets minus current liabilities on the balance sheet but excluding from current liabilities those accounts that are purely financial in nature. The excluded accounts are related to financial asset investing and are not operational in nature (that is, they exist for financial investors to earn a rate of return, which is not the case, for example, for accounts payable). Accounts that reasonably can be excluded are dividends payable, short-term debt, and the current portion of long-term debt. Trade capital is similar to net working capital. Net working capital is defined as current assets less current liabilities. The difference between trade capital and net working capital is that trade capital excludes any current liability that is financial and exists because an investor is looking to earn a rate of return. For 2012, we calculate Canadian Pacific s Trade Capital as all of their Current Assets less Accounts Payable. TC 12 = $1,334,605 - $1,190,960 = $143,645. Exhibit 2-4 below gives this number as part of Invested Capital for CPR in the operating calculation for yearend The second business investment that firms make is net fixed assets (plus other long-term business investments). This investment is required to support the long-term production and commercial activities of the firm. Net Fixed Assets (NFA) equal the cost basis of fixed assets, net of accumulated depreciation. For CPR we measure long term business investment as Plant, Property, and Equipment (Net of Accumulated Depreciation) plus Other Long Term Assets (Intangible Assets and Other Assets). So, for year-end 2012 for CPR their NFA plus other longterm business investments in Exhibit 2-4 is: NFA 12 +Other =13,067, , ,595 = $13,454,

20 Financial Statements in Financial Analysis The sum of trade capital, net fixed assets and other assets (as appropriate) equals invested capital. In exhibit 2-4 below, Invested Capital for CPR at year-end 2012 is: IC 12 = 143,645+13,454,509 = $13,598,154. So, at year-end 2012, the total business investment of CPR, short-term and longterm, is over 13.5 billion dollars. The amount financial asset-holders have invested in the firm must equal the equal the business investments of the firm. In exhibit 2-4 below, we rearrange the accounting balance sheet into an Invested Capital Balance Sheet. The right-hand side shows the investments made by financial asset-holders. The left hand-side shows business investment by the firm. In either case, the financial perspective or the operating perspective, expenditure as measured by invested capital at year-end 2012 for CPR is $13,454,509. So, our invested capital balance sheet balances! Invested Capital Balance Sheet Canadian Pacific Railway Invested Capital Operating 31-Dec Dec Dec Dec Dec-09 Trade Capital 789, , , , ,400 NFA+Other 14,130,864 13,454,509 13,016,000 12,552,000 11,936,300 Invested Capital 14,920,561 13,598,154 12,744,000 12,749,000 12,547,700 Invested Capital Financial Debt 8,248,567 8,479,656 8,178,000 7,894,000 8,104,100 Equity 6,671,994 5,118,498 4,565,000 4,855,000 4,443,300 Invested Capital 14,920,561 13,598,154 12,743,000 12,749,000 12,547,400 ROIC (BOP) ROE (BOP) effective tax rate debt/ic implied interest rate on debt Exhibit 2-4: Invested Capital Balance Sheet 20

21 Intro to Finance (2.6) Business Returns Title Page We design and calculate the invested capital balance sheet in Exhibit 2-4 above because we need a good measure of expenditure for a good return measure. Returns are critically important in financial analysis. In our first numerical example of this book, a firm invests $300,000 to generate $400,000 in one year. If the opportunity cost rate of return from financial markets is 7% per annum, the NPV (wealth creation) for financial asset-holders and shareholders in particular is $73,832. Because this number exceeds zero, we conclude in chapter 1 that this is a good business investment and should be undertaken by the firm. However, it is hard to assess without further analysis whether this is an exceptional good investment or only a marginally good business investment. Because we all have a basic understanding of what constitutes a good or a bad rate of return from financial markets (in fact, the 7% in the above example give us this understanding), if we can calculate business returns then we can assess whether this investment is exceptionally good or only marginally good. There are two principal business returns and, further, they relate one to the other. The first is the rate of return that a firm earns when it makes its business investments. We call this rate of return the rate of return on invested capital (ROIC) and we typically calculate it after depreciation and after tax. So, we call it the rate of return on invested capital after-tax and after depreciation. In addition, because financial asset-holders finance business investments, we sometimes referred to this return as the rate of return that a firm earns for all its financial asset-holders (generally creditors and common shareholders). Second, we have a special interest in shareholders because of our presumption that the primary objective of managers in operating a business is to maximize shareholders wealth. So, our second business return measures the return a business earns for shareholders specifically. We call this return the rate of return on equity (ROE). In the following two sections, we investigate these two business returns. Then, we investigate how ROIC and ROE relate to one another and how one is a relative benchmark for the other. Finally, we answer the question why both ROIC and ROE are IRRs. 21

22 Financial Statements in Financial Analysis The principal determinants of business returns and opportunity cost rates of return are very different. The primary determinants of opportunity cost rates of return are interest rates in the economy and risk because investors in financial market trading determine opportunity cost rates of return. On the other hand, the principal determinant of business returns (both ROIC and ROE) is corporate profitability. Don t confuse business returns with opportunity cost rates of return The Rate of Return on Invested Capital (ROIC) Title Page The rate of return on invested capital is the rate of return on a firm s business investment for all financial asset-holders. It is not a rate of return on market-value (like a share price, for example) but a rate of return on expended funds. The comparison of rates of return on expended funds to rates of return on market values (opportunity cost rates of return) is an important corporate performance benchmark we develop in this book. The rate of return on invested capital (before tax and before depreciation) is EBITDA divided by invested capital at the beginning of the period (BOP). Any financial return calculation uses funds invested at the beginning of the investment period relative to benefits received over the course of the period. We abbreviate the rate of return to invested capital as ROIC. ROIC = Rate of Return on Invested Capital (ROIC) = EBITDA Invested Capital (b.o.p.) There are a number of variants and more comprehensive measures for ROIC. In particular, the rate of return on invested capital after-tax and after depreciation is EBIT times one minus the corporate tax rate divided by invested capital at the beginning of the period. The return recognizes not only forecast replacement of deteriorated assets (with depreciation) but also taxes arising from business investment and deductibility of depreciation for tax purposes 3. 3 The distinction between financial statement depreciation and depreciation for tax is not made in this return. 22

23 Intro to Finance ROIC after- tax and after depreciation = EBIT (1- tax rate) Invested Capital (b.o.p.) For CPR for 2013, EBIT from Exhibit 2-1 is $1,335,903. Also from Exhibit 2-1, the effective tax rate (Income Tax Expense divided by Income before Tax) for CPR for 2013 is 22.22%. Since beginning of period for 2013 is end of period for 2012, IC BOP is IC 12 from the invested capital balance sheet in Exhibit 2-4, which is 13,598,154. Because we anticipated IC 12 for the 2013 ROIC for CPR, we discussed above Invested Capital in the operating and financial calculations for 2012 rather than for ROIC after-tax and after depreciation for CPR for 2013 is, ROIC 13 = 1,335,903 ( ) 7.6% 13,598,154 At the beginning of this chapter we said that the theory of business is not sufficiently strong to give us absolute standards for most ratios and, thus, most ratios we benchmark with relative and weaker benchmarks like trend analysis or industry comparison. However, the exception to this statement is returns from finance. Because ROIC is a return, we can benchmark it with an opportunity cost from financial markets, which is a number and, thus, an absolute standard. We learn later in this book how to calculate opportunity cost rates of return from financial markets to benchmark the business returns. However, we have to learn more about financial markets in upcoming chapters before we can calculate these opportunity cost rates of return and determine the above business return for CPR is high or low. Ignoring other income, which corporations sometime have, we can write ROIC after tax and after depreciation in the following form. Because stylized companies we give in end-of-chapter problems will not have other income this return calculation might be useful for you, ROIC after-tax after depreciation = EBITDA deprec (1-tax rate) Invested Capital (b.o.p.) 23

24 Financial Statements in Financial Analysis The Rate of Return on Equity (ROE) Title Page If the primary objective of managers is maximizing shareholders wealth, then an important measure of corporate performance is the rate of return that the firm earns on funds originally invested by shareholders. We calculate the rate of return on equity (ROE) as net income divided by book equity at the beginning of the period, ROE = Net Income available to common Book Equity (b.o.p.) Net income for 2013 for CPR in Exhibit 2.1 is $822,600. Book Equity (BOP) for 2013 is Book Equity 2012 in the Invested Capital balance sheet in Exhibit 2-4, which is $5,118,498. Thus, 2013 ROE for CPR is, ROE = Net Income 822, % Book Equity (b.o.p.) 5,118, 498 We have a three observations about this return. First, like our discussion above for ROIC we do not know immediately whether 16.1% is high or low. However, because ROE is a return, we can benchmarked it with an absolute standard, which is an opportunity cost from financial markets. We learn later in this book how to calculate opportunity cost rates of return from financial markets to determine whether ROE 13 = 16.1% is high or low. Second, notice that ROE 13 = 16.1% > ROIC 13 =7.6%. There are two primary reasons why ROE>ROIC (although it is not always the case). We identify these two reasons in End of Chapter Question #5. Third, ROE and ROIC (after tax and after depreciation) are relative benchmarks for one another. As we said above, the primary determinant of business returns, both ROIC and ROE, is corporate profitability. Because corporate profitability is common to both, they tend to move together. When one is high, both are high, and ROE exceeds ROIC. If one is low, both are low, and ROIC exceeds ROE. The converse of these statements is also true. If ROE > ROIC (like for CPR in 24

25 Intro to Finance 2013), then both business returns are relatively high and this is a relative good year for corporate profitability for this firm. We cannot yet say whether ROE or ROIC is high or low because we don t yet have an opportunity cost rate of return as an absolute benchmark, but we do know that 2013 was as relatively good year for corporate profitability for CPR. Because ROE and ROIC move together (that is, when one is high they are both high), there must be a formal relation between them. We identify this relation in the following section. However, before we develop this relation, we do one more thing with ROE. A second way to calculate ROE beyond the above (and the following section) is with the Dupont formula, which multiplies three ratios together: net profit margin, invested capital turnover, and invested-capital to equity. These ratios are sometimes called the levers of performance because ROE increases as they increase. However, we warn the reader that if managers increase ROE by increasing the IC to Equity ratio (that is, they use more debt to finance their business investments), then risk borne by shareholders also increases. So, increasing ROE by increasing a firm s financial leverage is not necessarily a good thing. ROE =Net Profit Margin Invested Capital Turnover Invested Capital to Equity = Net Income Sales Sales IC (b.o.p.) IC (b.o.p.) Equity (b.o.p.) = Net Income Equity (b.o.p.) Net profit margin measures profitability per dollar of sales for shareholders. Invested capital turnover measures sales per dollar of business investment. The invested capital to equity ratio is a financial leverage ratio that measures invested capital per dollar of equity. For CPR in 2012, invested capital to equity is $13,598,154/5,118,498=2.66. Net profit margin for 2013 is $822,600/5,765,723= 14.3%. Invested-capital turnover (BOP) is 5,765,723/13,598,154= ROE is, thus, ROE = = 16.1% 25